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Economic SYNOPSES short essays and reports on the economic issues of the day 2007 ■ Number 15 Inflation Disconnect? Riccardo DiCecio eadline inflation is the percentage change in the price not be reasonable to conclude that monetary policy has been index for a basket of goods and services. Core inflation effective in maintaining price stability by looking solely at a core measures the underlying trend in inflation, i.e., the commeasure of inflation that excludes sustained oil price increases. ponent of inflation most closely linked to monetary policy actions However, one must keep in mind that an increase in energy prices in the longer term. The most common way to measure core inflacould present monetary policymakers with a trade-off between tion is to exclude food and energy from the set of goods and controlling inflation and stabilizing the output gap (i.e., the differservices. The rationale for excluding food and energy prices is ence between actual and potential output) if these price increases that historically they have been highly volatile and high volatility affect actual output more than potential. The optimal resolution tends to mask the underlying inflation trend. But why always of this trade-off is an active area of research.3 exclude these two classes of goods while including others? In sum, price indices provide a snapshot of the dynamics of The difference between headline inflation and the most comprices of a basket of goods and services. However, because each monly used measure of core inflation (less food and energy, or core index suppresses a different source of information, they each XFE in short) has been increasing since early 2004, for both provide a different measure of inflation. Especially in times of consumer price index (CPI) inflation and personal consumption substantial relative price movements, all price indices should be expenditures (PCE) inflation. The gray line in the chart illustrates considered by policymakers and analysts. ■ this by showing a 5-year moving average of the difference between 1 Mick Silver, “Core Inflation Measures and Statistical Issues in Choosing Among headline CPI inflation and CPI-XFE inflation. The discrepancy Them,” Working Paper No. 06/97, International Monetary Fund, April 2006. between these two indices reflects the sharp and sustained increase 2 Kristie M. Engemann and Michael T. Owyang, “Hard ‘Core’ Inflation,” Federal in the price of oil between mid-2004 and mid-2006. The inflation Reserve Bank of St. Louis Monetary Trends, February 2005. rate of the energy component of the CPI (CPI-E) has been grow3 For a comprehensive review of this literature, see Lutz Kilian, “The Economic ing much faster than the overall CPI. (The blue line in the chart Effects of Energy Price Shocks,” Journal of Economic Literature, forthcoming. shows the difference between the two.) The academic literature is increasingly focused on limited-influence estimators to measure core inflation.1 CPI Inflation Rates: Headline, Core Measures, and Energy In fact, the Federal Reserve Bank of Cleveland calcu(5-year moving averages of annualized % change) lates two such monthly measures of core inflation: the Energy Inflation Monthly Headline Inflation weighted median2 and the trimmed mean CPI inflation minus Headline Inflation minus Core Inflation rates. These measures exclude the items facing more 1.5 20 CPI-E minus CPI extreme price movements in each time period, resulting (right axis) 15 1.0 in a different basket of omitted items each period. 10 Proponents have argued that limited-influence meas0.5 ures of core inflation have superior statistical properties 5 and, in particular, are better at forecasting headline infla0.0 0 tion. The black line in the chart shows the difference –5 between headline inflation and core inflation, measured –0.5 by the 16 percent trimmed mean CPI inflation (CPICPI minus CPI-TMI –10 (left axis) TMI). This smaller difference between core and headline –1.0 –15 CPI minus CPI-XFE inflation suggests that discrepancies between headline (left axis) and core inflation are partly induced by the way core –20 –1.5 Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan inflation is defined and measured. 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 A disconnect between measures of headline and core SOURCE: Bureau of Labor Statistics; Federal Reserve Bank of Cleveland; Haver. inflation could be a concern for policymakers: It may H Views expressed do not necessarily reflect official positions of the Federal Reserve System. research.stlouisfed.org
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